Long-Term Incentives and Non-Qualified Plans for Privately-Held Companies Trends and Challenges. Authored by: Bob Lindeman and Steven Sullivan

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1 white paper Long-Term Incentives and Non-Qualified Plans for Privately-Held Companies Trends and Challenges Authored by: Bob Lindeman and Steven Sullivan February

2 Our U.S. businesses continue to recover from a period of economic challenges which have upended organizations in all industry sectors and across all positions of the value chain. Many business models that were solid a couple of years ago have become irrelevant in a new economic environment that continues to define itself each day. Capital has been as scarce as it has been critical for many companies. Executives have found it difficult to instill a sense of direction and optimism among their employees during this period of economic uncertainty. As business owners and stakeholders strive to anticipate the changing needs of their customers, they must re-evaluate and modify their own company s business model. The renewed focus on drivers of long-term shareholder value and what is important requires a more innovative and agile business enterprise characterized by: Longer-range view of the business model Increased innovation Increased flexibility and agility Improved performance visibility, planning and analysis Change processes to build sustainable value Increases focus on human capital management Simultaneously, business owners wish to minimize fixed costs and by utilizing variable compensation opportunities to link the interests of company executives with their financial goals. There has consequently been a significant increase in the amount of attention focused on executive compensation within privately-held companies. It is through various long-term incentive programs that companies can establish a proper linkage between long-view enterprise success and the opportunities afforded their executives and senior managers to earn a significant payout in the future. The primary vehicle for rewarding executives in publicly-held companies is stock, either through stock options or restricted stock. However, stock is not always available in privately-held companies. Nonetheless, privately-held companies still need a sound long-term compensation program to engage high-quality executives and key managers in their journey out of a recession and into building sustainable enterprise value. The following discusses some of the reasons for this emphasis in long-term compensation as well as some pitfalls in the design and implementation of these plans and how to avoid them. Types of Long-Term Compensation There are two different types of long-term compensation plans: long-term incentive and nonqualified deferred compensation plans: Long-term incentives provide executives with long-term financial opportunities that are based on performance; primarily corporate performance. Stock options and restricted stock are primarily used by public companies, and stock appreciation rights and phantom stock are often used for privately-held companies. Non-qualified deferred compensation plans provide executives with long-term financial opportunities that are not based on performance. Supplemental retirement plans are examples of non-qualified deferred compensation plans. Need for Long-Term Compensation Many executives in public companies have earned significant amounts of compensation through longterm programs, sometimes due to, or other times in spite of, corporate performance. Accordingly, longterm incentive arrangements have been subject to substantial scrutiny and in some cases have been reduced. However, this comes at a time when there is actually an increased need for long-term compensation in public and private companies alike, for some of the economic reasons discussed earlier, and also those listed below: Demographic Trends: Baby boomers have begun retiring en masse starting in 2007 and that trend will continue for the next 18 years. It is projected that 26.6 million US workers will be age 55 or older in 2010, and many baby boomers are concerned about the ability of Social Security to fund their retirement. It is a fact that the ratio of workers to retirees will shift radically in the next twenty years. As such, various economic and financial planners estimate Social Security payments to retirees will be reduced to remain solvent. The boomers realize they only have a few more years to save and so are making their employers aware of their shortfall or in some cases Page 2

3 leaving their jobs to find employers with better retirement or long-term incentive packages. Retirement Plan Shortfalls: Even if executives contributed to their 401K at maximum levels, it may not be sufficient to fund their retirement if their employers did not provide pension plans or nonqualified plans as well. Very few privately-held companies (less than 3%) offer defined benefit pension plans compared to 17% of all employers. 401K plans did not become available until the 1980s when the early baby boomers were already reaching the age of There is a big difference in the amount a person can save over years versus 20-25years because of the power of compounding. For these reasons, many managers and executives have not or will not be able to replace 70% or more of their pre-retirement income if they plan to retire at age 62 (the national average age for retirement per the 2000 Bureau of Labor Statistics). The 70% retirement ratio is the general rule of thumb that financial planners use as an estimate for the income retirees will need to maintain the lifestyle equivalent to that prior to retirement. Ability to Attract: Many privately-held companies realize that the talent they need either comes from publicly-held companies or larger privately-held companies that most likely already have long-term incentive or non-qualified plans. To attract this talent, the privately-held company must implement one of these plans or be forced to increase base salary and/or short-term incentives significantly to compensate for the lack of a long-term plan of some kind. Ability to Retain Key Talent: The war for talent has always been considerable, but will increase exponentially as the economy recovers and baby boomers retire. Also, talented people are no longer staying at only one or two companies throughout their career. There are three compelling reasons for shorter tenure: Companies are less loyal to their employees as evidenced by layoffs and downsizing The reduction in defined pension plans or generous retirement programs to retain employees The stigma of job hopping has disappeared as people move every five years or so Long-term incentive and non-qualified deferred compensation plans can help retain an organization s key people by: Offering something other privately-held companies may not offer Making the walk-away cost significant enough to make them think twice before leaving for other opportunities Economic Times: Before the recession, the economy grew nicely with GDP increasing 3-5% per year and the overall stock values of both privatelyand publicly-held companies have notably increased in value over this same period of time. The Wilshire 5000 index is the summary of the total publicly-held market, and it averaged returns in the mid teens during the last three years before the recession. For privately-held companies, there is no index for valuation, but as the private equity firms experience increased profitability and revenue during the recovery this will drive their valuation upward similar to the publicly-held sector. Long-term compensation programs usually gain renewed interest during growth periods. Private Equity Firm Impact: In the last five years, private equity firms have aggressively focused on privately-held companies for acquiring a partial or full interest. There are some estimates that private equity firms will own over 50% or more of privately-held companies within the next 10 to 5 years. Private equity firms almost always provide current or new management with generous long-term incentives focused on value creation to attract, motivate and retain top talent. This is quickly beginning to change and influence compensation packages of privatelyheld companies. Ownership/Management Succession: As baby boomers continue to age, ownership/ management succession is becoming more important. Many owners need key management talent to run their companies as they position themselves for any one of the following succession alternatives: Transition the business to the next generation of family (Family Business Model) Owners plan to shift to part-time or full-time retirement, yet remain owners (Owner Investment Model) Page 3

4 Owners partially or totally cash out with an ESOP (Employee Stock Ownership Plans) Ownership sells partially or totally to management through a management buyout or internal transfer of ownership Ownership sells partially or totally to a private equity firm or strategic buyer In all of these cases, the need to retain key talent prior to and after a transaction or transition can be greatly enhanced with either a long-term incentive plan or a non-qualified plan. Without such plans in place, privately-held companies bear the risk of losing key people or not being able to attract them in the first place, possibly harming the value of their company and derailing their succession plans. Board of Director Cross-Pollination Many individuals serving as outside directors on private company boards may have also served, or serve on the board of a public company. These directors therefore are likely to be familiar with and favor the use of long-term incentives to align the agendas of investors and executives. All of the above stated factors are contributing to the growth in the use of long-term incentive plans or nonqualified plans. Plan Selection Assessing the need for a long-term incentive plan within an overall executive compensation program is a critical first step in evaluating the appropriateness of such a program for a given business. The next step in the process is selecting the most appropriate plan or long-term incentive vehicle. The key to choosing the most appropriate plan is to first establish some plan objectives and parameters. For example: Is stock available? Should the plan be performance-based? If performance-based, what criteria should be used to measure value? What is the appropriate timeframe? Are there any tax issues that should be considered? What are the cost considerations? What do potential plan participants perceive as valuable? Are there significant individual differences among your executive team which would prohibit a single approach? The answers to these questions will help form the basis for selecting the most appropriate long-term compensation plan for the company and executives. There are several key considerations in the selection of the most appropriate plan and in its design. The different types of performance based plans and nonperformance based plans are: Performance Based Stock Plans Qualified Stock Options Non-qualified Stock Options Incentive Stock Options Restricted Stock Non-Stock Plans Stock Appreciation Rights Phantom Stock Performance Unit Plan Restricted Stock Units Non-Performance Based Supplemental Executive Retirement Plans (SERP Deferred compensation plans An in-depth discussion of the pros and cons of each of these plans is not the subject of this article. Rather, the remainder focuses on the important steps of selection, design and implementation of these plans. Selection, Design and Implementation The decision to implement a long-term compensation plan can have a positive impact on the future success of the company. However, if the wrong type of plan is selected, or if it is not implemented properly, it can have a disastrous impact on the company and the morale of its executives. Nine common pitfalls in the selection, design and implementation of long-term compensation plans are discussed below: 1. No Compensation Strategy Review - Not determining how a long-term compensation plan fits with the company s overall compensation strategy. The company needs to look at how the total compensation package stacks up in terms of base salary, annual incentive, qualified Page 4

5 retirement plans and long-term compensation plans. Critical factors to consider are: How does the plan relate to our overall business strategy and culture? How does the plan relate to ownership objectives? What is the appropriate compensation mix? How does it compare to the competition? How does it compare to the general market? How variable is the plan based on performance? How does each component compare to the market? Who should be eligible to participate in the program? One of the objectives of any compensation program is to maximize the value of your compensation dollars. Determining the appropriate compensation strategy and selecting and designing a plan consistent with that strategy will help maximize the return on the required financial investment. 2. No Plan Selection Criteria - Ownership not clarifying and defining what they really want to achieve with a long-term plan for the employer and the participants. These requirements should be matched with what each type of plan offers to ensure the selected plan meets their needs. 3. Poor Plan Knowledge - Not fully understanding how these plans work and the advantages and disadvantages of each type of plan to the employer and the participants. The company should conduct necessary research at the beginning of the process to properly educate all parties concerned. If necessary, seek help from outside consultants. 4. No Cost Analysis - Not projecting the cost/benefit of the plan under various scenarios. Owners need to project how much they would like participants to earn based upon organizational level, years of service, company financial performance, sale of company or other considerations. In some cases, owners may want participants to earn just enough in their plan to augment their 401K, or they may want true wealth accumulation which would mean the selected plan should be worth far more than any qualified retirement program. 5. No Pay Versus Performance Modeling Not assessing the linkages between enterprise financial performance and associated plan award values. Poorly conceived performance-based plans may generate award levels at odds with the level of enterprise value created by the executive team; awards may result which are at one extreme or another, either too rich, generating too much cost and too much benefit compared to performance, or too lean without generating sufficient benefits to the participants when they have performed successfully. Modeling multiple scenarios over a five- to fifteen-year period, using optimistic, realistic and pessimistic financial forecasts will help minimize the likelihood of this occurring. The company should model the following: The impact on the balance sheet and the income statement given resulting corporate gains The potential benefit to the participants before and after taxes The impact on the company s tax liability 6. Poor Initial Communication - Not communicating the overall plan concept objectives, potential financial benefits and key provisions in an easy to understand set of communication documents. While the actual legal document may be complex because of typical legal verbiage and 409A rules, there is no reason a practical set of communication documents cannot be developed to compliment the legal document. These documents should be augmented with oral presentations when plans are rolled out. 7. Inappropriate Plan Provisions The company does not think through critical provisions and how they relate to the owner s objectives. It is important that the selected long-term compensation plan meet the needs of the company and participants for it to be successful. Therefore, great care must be taken to make important decisions now that will affect how the plan operates well into the future. Key issues to be decided upon include the following: Page 5

6 Vesting Timing of payouts Termination clauses Change of control provisions Use of Rabbi-trusts Non-compete and non-solicitation agreements For example, a rapid payout upon termination may make sense in some situations. On the other hand, an extended payout over 3-5 years may have diminished value in the participant s mind if the industry is risky or there is a concern about financial stability of the company. Conclusion Long-term compensation plans should be seriously considered for privately-held companies for the reasons stated above. In a nutshell, they can help companies attract, retain and engage the talent they require to drive the company s longer range vision. These plans, however, should be carefully designed and implemented with appropriate communications to ensure they achieve the desired results. A well thought-out plan can have a very positive long-term impact, while a poorly designed plan can have a major negative impact. 8. Little Ongoing Communication - Not reinforcing the plan through periodic communication. The long-term compensation plan will not be effective if it is immediately put in a drawer and left there. At least annually plan participants should receive a participant statement of their vested and unvested balances. This statement should be augmented by some verbal or written communication by top management, the board of directors or ownership discussing company results and reinforcing plan objectives. 9. Lack of Periodic Plan Review - Not reviewing the plan s results and effectiveness. Annual incentive plans are usually revisited annually and performance targets and formulas are changed based on budgets and goals for that plan year. However, long-term plans are not intended to change from year to year. It is usually not appropriate to change plans unless the plan is not meeting the company s objectives or if there are problems with plan mechanics, legal or tax issues. To tinker with long-term plans too much can not only cost money, but breed mistrust or unwanted complexity. However, it is important for the company to periodically review the effectiveness of the long-term compensation plan in terms of achieving its objectives. If the plan is working properly, then no change is required. However, if it is determined the plan is not effective or causes problems, modifications or replacement may be required. Page 6